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The analyst shares his view on the U.S. markets, the dollar and trends affecting emerging markets

To gauge the various factors influencing international markets today and where the best investing opportunities are, AdvisorOne spoke with Chris Philips, senior analyst in the investment strategy group at Vanguard.

What are the most important global-investing themes or issues today for you and your organization?

Philips: What we are seeing in 2011 is quite contrary to what many expected last year. The United States has outperformed the emerging markets and other developed markets. If you’d polled those in our industry at the very beginning of this year, I don’t think anyone would have predicted that we’d be where we are. The relative performance of the U.S. vis-à-vis the emerging markets speaks to the uncertainty out there and the difficulty of predicting returns, particularly in the short run. And there are some significant risks in the global markets, such as the nuclear crisis in Japan and the ramifications of this issue going forward

There is also the potential broadening and deepening of the euro crisis. In addition, we have [high] oil prices and the prospect of inflation, which are some of the risk factors the market is trying to price in – almost on a daily basis. That type of volatility and these risk factors are what we keep an eye on.

What positive investment opportunities do you see based on the trends you described earlier?

Philips: We are telling our investors that this is a great time tore-balance their asset allocations.To stray too far away from that allocation or place significant bets on Japanese stocks in anticipation of an economic rebound as they rebuild in the aftermath of the earthquake and tsunami, or betting wholesale on the emerging markets, could be just as risky as some of the earlier risks that I mentioned before.

After the financial crisis, stocks – both in and outside the United States – have had a tremendous bull run and are up anywhere from 80 to 90 to 100% from the bottom of the market in 2009. If you look at the average investor’s portfolio and they made no change to it during the crisis, the equity portion of their portfolio has grown along with the stock-market performance.

If they went into the bull run with a 50% stock and a 50% bond allocation, they may now have a 60-to-70% stock and a 40-to-30% bond allocation. And this could put some undue risk into the portfolio, given the chance of a correction or another bear market, which is why now is a good time to rebalance. We always recommend this course of action, especially when you see this type of a one-directional market. It can be difficult for investors to re-balance in a bull market, just as it can be tough to buy stocks in a bear market.

In terms of fixed income, we know that global bonds are the largest single asset class out there due to the significant issuance of government and corporate debt worldwide – especially over the past two to five years. Thus, investors interested in fixed income really need to think about the role it plays in their portfolio and what they gain as they diversify out of U.S. fixed income and into global fixed income. They are really getting currency exposure, which can be so volatile that it can overwhelm the diversification benefits of having global – rather than just U.S. – bonds in a portfolio.

The flipside of this is that if you are betting on continued depreciation of the U.S. dollar, global bonds make a lot of sense. And this would be more a tactical, short-term play, which can be very difficult to time and implement in a portfolio. Again, there are significant pros and cons with global bonds – but we recognize that they are the largest single asset class today and can play a role in portfolios if done correctly.

What about other areas of potential opportunities and/or risks?

Philips: When looking at price-to-equity or PE ratios in the developed markets – Europe, the Pacific and Canada –we see that PEs are relatively low and have come down significantly since the

late 1990s and early 2000s. This is a bit of a contrast with what we’ve seen in the United States, and overall, PEs are fairly attractive in the developed markets.

In emerging markets, they’ve also been fairly constant and normal – and are in an attractive range; yes, there’s been tremendous price movement in emerging markets, earnings have kept pace, and this leads us to expect fairly normalized returns going forward, which is beneficial to investors. We just came off a lost decade for both U.S. and non-U.S. stocks, and in the future, we see possibility of that happening again as being less than it was in the 1990s, when there were elevated PEs. And again, with non-U.S. stocks, we are definitely in the attractive range.

Would you like to comment on other global dynamics affecting international investing at this time?

Philips: One of the most fascinating developments we see today involves the dynamic between the Asia-Pacific region and Europe. In the middle of last year, with troubles in Greece, Ireland, Spain and elsewhere, along with the euro crisis, European stocks underperformed. At one point, they were down 20 to 25%. On the flipside, Asia-Pacific stocks – largely driven by Japan – were basically flat but were outperforming European stock by about 20%; and during all of the this, U.S. stocks were doing quite well.

For a while, you had European and Asia-Pacific stocks on a tear, but the Japan earthquake – of course – has very much hurt the Asia-Pacific performance, though there has been a bit more upside lately. Meanwhile, we had the tale of the euro crisis, and then these markets shot up significantly. These situations are difficult to judge, given the uncertainties in countries like Portugal and Japan. Such unanticipated events can certainly impact return patterns going forward.

As a result, when we speak with investors about being in international stocks, we speak about being as well diversified as possible as opposed to taking a regional or a more narrow focus. The Russian stock index, for instance, is dominated by one or two companies. And there is also a heavy natural-resource concentration in this market, which makes this market extremely volatile.

Finally, we like to speak about an international allocation being 20 to 30% of a portfolio. Many investors are not there yet, but some are clearly on their way.

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